In March of this year, we saw two important cases of short-swing profit recovery come to a close. First, the New York Federal Court approved the settlement against two hedge funds for the recovery of short-swing profits resulting from trades of CSX stock (preliminary announcement from the CSX website ). Two unusual aspects of this case are the inclusion of derivative securities in the calculation of shares beneficially owned, and the definition of a “group” for the purposes of determining shares beneficially owned (see Alan Dye’s Section16.net Blog for more details)

The second final ruling was a denial by the U.S. Supreme Court to allow InfoSpace founder Naveen Jain to sue his stock management company for trades relating to Jain’s 2003 short-swing profit recovery judgment — see “Supreme Court turns down appeal from InfoSpace founder (The Seattle Times, March 9, 2009). In 2003, Jain’s case was one of the largest settlements rulings at the time. The judgment was for $247 million, although he settled for $105 million. Jain’s case is important because it highlights that the courts are not likely to allow insiders to recover losses that were alleged to be the fault of actions by another party.

Both of these cases illustrate the complexities involved with short-swing profit recovery.

On the surface, short-swing transactions may appear to be basically straight forward. Section 16(b) of the Securities Exchange Act of 1934 requires Section 16 insiders to return any profits realized by two non-exempt opposite-way transactions that occur within six months of each other. It isn’t relevant which of these transactions takes place first, or even if the transactions resulted in real profit for the insider.

Additionally, the transactions covered include any non-exempt transactions in the company’s shares that are even beneficially owned by the Section 16 insider. This includes transactions by family members or entities in which the insider is a controlling member. For example, if a Section 16 insider sells 1,000 shares of company stock at $10 a share and the insider’s spouse later within the six-month period purchases 1,000 shares at $5 per share, these two transactions could be matched for short-swing profit recovery. The company should recover the difference of $5 per share, or $5,000.

Short-swing profit recovery is designed to discourage insiders from taking advantage of inside information about the company to realize short-term profits. However, the intent behind transactions isn’t relevant; only the outcome. Unlike insider trading, there are no fines or criminal charges that are associated with short-swing profits (although the repayment to the company of the calculated profits can be a very serious loss for the insider).

If the company fails to uncover short-swing profit or does not require the insider to repay the profit, then a shareholder may bring the transactions to the attention of the company. In most cases, that shareholder is entitled to an “attorney’s fee”, which is taken from any profits recovered by the company. This fee is negotiated in a private settlement, and could be a significant amount of money. Because of this, there are attorneys who monitor insider transactions hoping to find short-swing transactions that resulted in a calculated profit.

Your company should include information about Section 16(b) and short-swing profit recovery in the insider trading policy. It is important that your Section 16 insiders understand:

1. Which transactions may be matched for the purposes of short-swing profit recovery,
   how ‘profit’ is calculated,
2. who at the company is available to discuss transactions with the insider (the compliance officer, for example),
3. that the insider is ultimately responsible for any Section 16(b) liability,
4. and to stress that any shareholder may sue the insider for profit recovery if the company does not require the insider to disgorge profits on short-swing transactions.

-Rachel